Question: How do the health FSA carryover and grace period provisions affect HSA eligibility?
Compliance Team Response:
General Rule: HSA Eligibility
The general rule is that an individual must meet two requirements to be HSA-eligible (i.e., to be eligible to make or receive HSA contributions):
- Be covered by an HDHP; and
- Have no disqualifying coverage (generally any medical coverage that pays pre-deductible)
General Rule: Health FSA is Disqualifying Coverage
Coverage under a general purpose health FSA for the employee or spouse is disqualifying coverage for both individuals. This is because an employee can reimburse pre-deductible expenses under the health FSA for both the employee and the spouse.
The result is that if either spouse is enrolled in a general purpose health FSA, neither spouse is HSA eligible. They can still be covered by an HDHP, but they cannot make or receive HSA contributions.
For more details, see our previous entry here: https://www.theabdteam.com/blog/hsa-interaction-health-fsa/
HSA Eligibility: $500 Health FSA Carryover
Employees who want to move from non-HDHP coverage in year one to a HDHP in year two have a potential HSA eligibility issue if they were enrolled in the health FSA with a carryover provision. If an employee carries over any amount as a general purpose health FSA balance into year two, the carryover will block HSA eligibility for all of year two.
In other words, unless there is a process in place to avoid it, the carryover will prevent the employee from being eligible to make or receive HSA contributions in the subsequent plan year when covered by the HDHP.
Fortunately, the IRS has approved two approaches for employees to be HSA eligible when they have unreimbursed health FSA contributions subject to the $500 carryover:
- Preferred Approach: Automatic Conversion of Carryover Balance to Limited Purpose
Under this most common approach, the health FSA can be structured to automatically convert the general purpose carryover amount to limited purpose where the employee is moving to HDHP coverage the subsequent plan year.
This is the preferred method for addressing the issue because it preserves the full carryover amount without compromising the employee’s ability to make or receive HSA contributions when moving to HDHP coverage.
- Fallback Approach: Election to Forfeit Carryover Balance
This less common approach permits the employee to waive the general purpose carryover balance and have it forfeit to the plan. It is not as desirable an approach as the first option because the employee loses access to the carryover amount (as opposed to simply converting the funds to limited purpose).
This option is generally useful only for employers that do not offer a limited purpose health FSA. Although it is less advantageous than the first option, it at least permits the employee to avoid having a small carryover balance block HSA eligibility for the entire subsequent plan year.
- Manny moves from a standard non-HDHP medical plan in 2019 to an HDHP in 2020.
- He has $10 remaining of general purpose health FSA balance from 2019 that will carry over into the 2020 plan year.
- Manny’s employer’s plan utilizes the first approach above to automatically convert general purpose carryover balances to limited purpose whenever an employee moves to an HDHP for the new plan year.
- The limited purpose health FSA carryover balance will not block Manny’s HSA eligibility!
HSA Eligibility: Health FSA Grace Period
Employees who want to move from non-HDHP coverage in year one to a HDHP in year two have a potential HSA eligibility issue if they were enrolled in the health FSA with a grace period provision. If an employee has any general purpose health FSA amounts remaining at the end of the plan year, the 2 ½-month grace period will block HSA eligibility for the first three months of the next plan year.
In other words, the employee will not be HSA eligible until month four in year two (i.e., April for a calendar plan year) because the grace period will be disqualifying coverage for the first three months.
There are two main ways to avoid this grace period-related HSA eligibility issue:
- Spend Down the Account Balance to Zero By End of Plan Year
If the employee spends down the health FSA to zero by the last day of the plan year, the grace period will not affect HSA eligibility.
This spend down is on a cash basis, which means the account balance must actually be zeroed out by reimbursements no later than the last day of the plan year. Claims incurred/submitted but not yet reimbursed do not affect the cash basis determination.
- Uncommon: Automatic Conversion of Grace Period Balance to Limited Purpose
The health FSA can be structured to provide that all general purpose grace period amounts are automatically converted to limited purpose.
Unfortunately, this approach requires that the grace period amount be converted to limited purpose for all health FSA participants—even those who are not moving to HDHP coverage for the next plan year. It is therefore uncommon to see health FSA plans designed with this feature.
- Manny moves from a standard non-HDHP medical plan in 2019 to an HDHP in 2020.
- He is enrolled in the company’s general purpose health FSA that has a 2 ½-month grace period at the end of its calendar plan year (until March 15 of year two).
- Manny has his entire $2,700 health FSA account balance reimbursed prior to December 31, 2019 (not just claims incurred or pending—but actual reimbursement of the full amount).
- Manny is HSA eligible (assuming no other disqualifying coverage) as of January 2020.
- The grace period does not affect Manny’s HSA eligibility in January-March because the full balance was reimbursed prior to the end of the 2019 plan year.
For more details on this and all other HSA issues, please see our ABD Office Hours Webinar: Go All the Way With HSA.
IRS Chief Counsel Advice 201413005:
A cafeteria plan that offers both a general purpose health FSA and an HSA- compatible health FSA may automatically treat an individual who elects coverage in an HDHP for the following year as enrolled in the HSA-compatible health FSA and carry over any unused amounts from a general purpose health FSA to the HSA compatible health FSA for the following year.
A cafeteria plan may provide that if an individual participates in a general purpose health FSA that provides for a carryover of unused amounts, the individual may elect prior to the beginning of the following year to decline or waive the carryover for the following year. In that case, the individual who declines under the terms of the cafeteria plan may contribute to an HSA during the following year if the individual is otherwise eligible under section 223(c)(1)(A).
IRS Notice 2007-22:
Under the Act, if an individual has a zero balance in a general purpose health FSA, as determined on a cash basis, on the last day of the health FSA plan year, the individual does not fail to be an eligible individual as of the first day of the immediately following health FSA plan year because of coverage during a health FSA grace period.
For all purposes, balances are determined on a cash basis. Cash basis means the balance as of any date, without taking into account expenses incurred that have not been reimbursed as of that date. Thus, pending claims, claims submitted, claims received or claims under review that have not been paid as of a date are not taken into account for purposes of determining the account balance as of that date. In addition, the balance as of any date of a health FSA is determined by applying the uniform coverage rule (i.e., maximum reimbursement available for the plan year reduced for prior reimbursements paid as of the date for the same plan year). See Prop. Treas. Reg. § 1.125-2, Q&A-7(b)(2).
(iii) for taxable years beginning after December 31, 2006, coverage under a health flexible spending arrangement during any period immediately following the end of a plan year of such arrangement during which unused benefits or contributions remaining at the end of such plan year may be paid or reimbursed to plan participants for qualified benefit expenses incurred during such period if—
(I) the balance in such arrangement at the end of such plan year is zero, or
(II) the individual is making a qualified HSA distribution (as defined in section 106(e)) in an amount equal to the remaining balance in such arrangement as of the end of such plan year, in accordance with rules prescribed by the Secretary.
IRS Notice 2005-86:
(2) Mandatory Conversion from Health FSA to HSA-compatible Health FSA for All Participants
Employer amends the cafeteria plan document to provide for both a grace period and a mandatory conversion of the general purpose health FSA to a limited-purpose or post-deductible FSA (or combined limited-purpose and post-deductible health FSA) during the grace period. The amendments do not permit an individual participant to elect between an HSA-compatible FSA or an FSA that is not HSA-compatible. The amendments apply to the entire grace period and to all participants in the health FSA who are covered by the grace period. The amendments must satisfy all other requirements of Notice 2005-42. Coverage of these participants by the HSA-compatible FSA during the grace period does not disqualify participants who are otherwise eligible individuals from contributing to an HSA during the grace period.
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).